Early Retirement Plan Withdrawal Tax Penalties

Tim Mossholder, Unsplash
@timmossholder

Thinking about tapping into your retirement savings early? Before you do, it's essential to understand the tax penalties that may come with it. Early withdrawals from your retirement accounts, like a 401(k) or IRA, often result in hefty fines and tax consequences. Knowing the rules and potential penalties can help you make informed decisions and avoid costly mistakes.

Also, you must remember that withdrawing from your retirement plan, like a 401(k), should be a last resort during difficult times. Taking funds out early not only depletes your retirement savings but may also result in significant penalties. It’s best to explore other options first to avoid compromising your long-term financial security.

What Happens When I Take from Retirement Early?

The government wants you to save money for your retirement. That's why there are tax breaks like the Retirement Savings Contribution Credit and penalties for early distributions from retirement plans.

In order to discourage people from using their retirement savings for anything other than retirement income, the IRS charges a penalty of additional tax on most early withdrawals from retirement plans. In general, an early distribution or early withdrawal is any money you take out of a qualified retirement plan before you reach the age of 59 1/2.

The easiest and most accurate way to report an early withdrawal and to determine if you owe any taxes on it is to start a free tax return on eFile.com. Based on your answers to several questions, we will prepare the correct forms to report any withdrawals you make from your retirement plan.

A qualified retirement plan is any of the following:

• A Traditional IRA or a Roth IRA
• An employee plan, such as a 401(k)
• An employee annuity plan, such as a 403(a)
• A 403(b) or similar plan for employees of public schools and tax-exempt organizations.

Generally, state or local government 457 plans are not considered qualified retirement plans and early distributions from these are not subject to a federal tax penalty (though there may be state penalties).

If you make an early withdrawal from a qualified retirement plan, the amount is added to your gross income unless you meet one of the early withdrawal exceptions. As part of your gross income, you will owe tax on the distribution at your normal effective tax rate. In addition to normal income tax, you will owe a 10% penalty of additional tax on the amount of the early withdrawal in unless you meet an exception.

How to Report an Early Withdrawal?

You should receive a Form 1099-R that tells you exactly how much you withdrew from your retirement plan and how much tax was withheld, if any. When you e-file with eFile.com, the tax app will report these amounts directly on your Form 1040 and help you report the 10% penalty as applicable.

In most cases, you also need to fill out Form 5329, Additional Tax on Qualified Plans - eFileIT. This form is used to calculate your additional tax penalty or to claim an exception. When doing your taxes on the eFile app, the tax interview will allow the app to determine if you need to e-file this form. If there is a 1 in Box 7 of your 1099-R, you don't need to fill out Form 5329, but you still need to report the distribution as income.

The easiest way to report an early withdrawal is to prepare and e-file your tax return using eFile.com. We will select the right forms for you and help make sure Form 5329 is filled out correctly. Note that if tax was withheld and you file by mail, you generally need to attach a copy of your 1099-R to your tax return. You don't have to worry about that if you e-file.

Additional Resources:

• How to enter an early withdrawal?
• Early IRA distribution and taxes
• Tax Guide for Retirees

Additional Tax Penalty for an Early Withdrawal

The tax penalty for an early withdrawal from a retirement plan (IRA, 401, etc.) is a flat penalty rate equal to 10% of the distribution. You must pay this penalty in addition to regular income tax.

If your tax withholdings and/or estimated tax payments are not enough to cover your taxes and the penalty, you will owe money when you file your return. Find out how to pay taxes you owe.

For example, let's say a 50-year-old takes an early distribution of $10,000 from a traditional IRA and is not entitled to waive the penalty as a qualified disaster-related withdrawal. This income is now considered regular, taxable income on their next tax return to be reported on their tax return with any other income and deductions from the year. The taxes owed on all this income would depend on the income tax rate of the individual, but, regardless of the tax rate, the flat 10% penalty is applied. This would result in a penalty of $1,000 for 10% of the $10,000 distribution in addition to federal and state taxes owed. This income may also push the individual into a higher tax bracket for this year since this one-time payment is not periodic or reoccurring.

Related: See qualified disaster relief deadline extensions and events.

The question is, can you pay the early withdrawal penalty when you take the withdrawal in order to avoid paying it later when filing taxes? Yes, you can, and it is actually fairly simple. For this, you have two options:

1. Elect for the distributor to withhold enough in federal taxes to cover the penalty. By default, companies will withhold 10% of the distribution when it is paid for federal income taxes, but you can submit a Form W-4P or W-4R to elect to withhold the additional 10% penalty. Note: this is not the same as a W-4 which you submit to your employer! You can search for free tax forms online here, including the retirement W-4 forms.
2. Make an estimated tax payment directly to the IRS and state (if applicable). When you do this, you can receive your full retirement fund distribution, minus the default withholding, and then make your own payment based on the penalty you are expecting to owe. This way, you can customize your payment more, perhaps only paying some of it since you need the money now and paying the rest when you file your taxes. Or, you can overpay now so you can get the difference refunded when you file. See how to pay IRS taxes online and, if applicable, how to pay state taxes here.

Otherwise, you can expect to pay the penalty when you file your taxes. If you normally expect a refund, this may offset your penalty.

Distributions that you rollover to another qualified retirement plan are generally not taxable and are not subject to the 10% additional tax penalty. Rollovers from a non-Roth account to a Roth account are taxable as income, but are not early distributions.

Exceptions to the Tax Penalty on Early Withdrawals

There are some exceptions to the 10% additional tax penalty. If you qualify for one of the exceptions, you still have to report your withdrawal as income, but you don't have to pay the 10% additional tax penalty.

The following exceptions to the penalty apply to early distributions from any qualified retirement plan, including IRAs:

• You have reached age 59 1/2.
• The distribution was made to your estate or beneficiary after your death.
• The distribution was made because you are totally and permanently disabled.
• The withdrawal was made to cover deductible medical expenses.
• The distribution was made to pay for an IRS levy.
• The withdrawal was a Qualified Reservist Distribution (generally, one made after being called to active duty for 180 days). See information on the military and taxes.
• The distribution was made as an installment in a series of equal and periodic payments over your life expectancy, or over the life expectancy of you and your beneficiary or beneficiaries. If the retirement plan is not an IRA, you must have left employment before payments began.

The following exceptions apply only to retirement plans that are Traditional or Roth IRAs:

• The distribution was made to pay the medical insurance premiums of you, your spouse, or a dependent while you were unemployed (or up to 60 days after re-employment).
• The withdrawal was made to cover qualified post-secondary education expenses.
• The distribution (up to $10,000 per spouse) was made to purchase a home for yourself, your spouse, or one of either of your parents, grandparents, children, or grandchildren if you/they are a qualifying first-time homebuyer (roughly, someone who did not own a home for the last 2 years). See details on the expired first-time homebuyer credit which some members of congress want to bring back.

The remaining exceptions below apply only to qualified retirement plans that are not Traditional or Roth IRAs:

• You received the distribution after you separated from service with your employer if you left employment during or after the year you turned age 55 (age 50 if the distributions were made from a qualified government benefit plan, if you were a public safety employee for a state or local government).
• The distribution was made to an alternate beneficiary or payee under a Qualified Domestic Relations Order.
• The distribution consisted of dividends from a qualified employee stock ownership plan, or ESOP.

Note that there are other, more rare exceptions and that the above descriptions do not take into account every detail of every situation. For more information on exceptions to the penalty on early withdrawals, refer to Publication 575 for non-IRA retirement plans and Publication 590 for IRAs. Note that Publication 590 comes in two parts: IRA Contributions and IRA Distributions.

Note: The following COVID information was for 2020 Returns. We are keeping it here if you need to file your previous year's tax return.

As a result of the June 2020 CARES Act, retirement account holders affected by the Coronavirus could access up to $100,000 of their retirement savings as early withdrawals penalty free with an expanded window for paying the income tax they owed on the amounts they withdrew. The regular 10% early withdrawal penalty was waived for COVID-related distributions (CRDs) made between January 1 and December 31, 2020. The CARES Act exempts CRDs from the 20% mandatory withholding that normally applies to certain retirement plan distributions. More details on retirement savings withdrawal and COVID-19. See this page to calculate your eligible amount for the third stimulus payment. If you missed the any of the stimulus check payments, learn what you need to do to claim them via the Recovery Rebate Credit. This was only for 2020 COVID-related withdrawals.

Related Information About Pensions and Retirement Income

• The Saver's Tax Credit may be claimed for retirement contributions.
• Maximum retirement plan contribution and pension plan limits directly affect how much you can put into your retirement plan(s).
• See taxable Social Security benefits.
• Minimum distribution amounts for retirement income determine the lowest amount you can withdraw after reaching a certain age.
• If your primary income is retirement income, see the best states to retire in.
• View the different kinds of 1099 forms you may receive.

TurboTax^® is a registered trademark of Intuit, Inc.
H&R Block^® is a registered trademark of HRB Innovations, Inc.